Friday, December 20, 2013

Richmond's Eminent Domain Program: It Could Really Happen

Richmond, California’s plan to use eminent domain to free city homeowners from underwater mortgages took a number of steps forward recently. Until this month, I would have given very long odds against Richmond actually going ahead with the plan, but now I would place the chances at close to 50/50.

The first development occurred last week in Washington with the Senate’s confirmation of Melvin Watt as Director of the Federal Home Finance Agency – which regulates Freddie Mac and Fannie Mae.  Under Acting Director Ed DeMarco, the agency had suggested it might prevent GSE financing in Richmond if the city moved forward with its plan to seize properties under the guise of eminent domain. The threat of not being able to get a Fannie or Freddie insured mortgage would have inflamed local opposition to the program. But, given Watt’s more progressive orientation, I doubt that he will continue DeMarco’s resistance. I suspect Watt is much more likely to look at the situation through the “little people vs. big banks” lens than his predecessor – whose career was devoted to the health of the home financing market.

The other developments occurred Tuesday night at the City Council meeting, the video of which is available here (most of the relevant discussion can be found between the 3 hour and 6 hour marks).  Mayor Gayle McLaughlin proposed and won passage of a motion that fine-tuned the program in a couple of important ways.

First, her measure imposed guidelines limiting the eminent domain program to mortgages below the conforming loan limit (now $729,750) and in struggling neighborhoods. This change addresses a revelation first made here at ExpectedLoss and later picked up in a WSJ blog and by the San Francisco Chronicle: that the program would have benefitted owners of some very expensive properties in affluent neighborhoods.

Second, the McLaughlin proposal calls for the eminent domain power to be exercised by a “Joint Powers Authority” rather than by the city itself. As reported by the Chronicle’s Carolyn Said, this change allows the eminent domain action to be approved by only a simple majority vote – rather than a super-majority as previously required. There appear to now be three solid “no” votes out of the seven officials who vote on the Council, so the need for a super majority appeared to be a deal breaker.  McLaughlin should be able to hold onto the four votes necessary to create the JPA and implement the eminent domain program. 

But the JPA device imposes a new challenge: another city would have to agree to participate in the JPA. Although McLaughlin and her supporters listed a number of potential partners in California and elsewhere, none of these cities have gone as far down the eminent domain path as has Richmond. Indeed, it is possible that none of these cities will ever get beyond the talking stage. This assessment applies especially to San Francisco – a city whose skyrocketing home prices have left few mortgages underwater.

A more likely candidate, El Monte, will need to be careful. The city declared a fiscal emergency in 2012 and some of its bonds carry non-investment grade ratings. Richmond has already been punished by the municipal bond market despite its superior fundamentals; it’s hard to see how a lesser credit like El Monte will attract investors if it goes ahead with eminent domain.

So the need to get a partner is a significant barrier – but not an insurmountable one. Undoubtedly, the ambitious folks at Mortgage Resolution Partners are very hard at work finding Richmond a mate. Of course, the path to finally condemning mortgages leads through the courthouse. Whether Richmond can prevail, with a very unusual interpretation of the takings clause, against a battalion of well-financed Wall Street lawyers is another bet entirely.

Thursday, December 19, 2013

Good Intentions are Not Enough: The Problem of SEC Mandated XBRL Reporting

Public companies have been required to supply financial reports since the Depression, but gathering and analyzing this disclosure has had its challenges. In the 1990s, the SEC began uploading 10-K’s and 10-Q’s to the internet, greatly simplifying the data collection task. These electronic reports were not standardized, creating the need for downstream users to write complex parsing algorithms and/or use manual processes to harvest the financial statements.

In the late 1990s, accounting and technology firms devised a standard called XBRL – eXtensible Business Reporting Language – to streamline the data acquisition process. XBRL disclosures rely on a common system of tags that consistently identify financial statement elements. The universe of elements differ amongst accounting standards, such as US Generally Accepted Accounting Principles (US-GAAP) and International Financial Reporting Standard (IFRS). An XBRL taxonomy lists all the acceptable financial statement elements for a given accounting standards.

Beginning in 2009, the SEC started requiring public companies to file 10-K and 10-Q disclosures in XBRL using a US-GAAP taxonomy – maintained by the accounting community and approved each year by the SEC.

Recently, I worked with UK-based OpenCorporates to gather SEC XBRL disclosures and harvest data from them. The goal was fairly simple: walk through all the XBRL documents and gather some basic parent company data points (like total assets, total liabilities, total revenue and net income) for the latest fiscal year from these disclosures.

This task proved surprisingly difficult because of a lack of standardization between XBRL documents from different companies. For example, many companies did not report a value for Total Liabilities. One might “back into” this value by subtracting Shareholders’ Equity from Total Assets, but this doesn’t always work. A small percentage of XBRL reports even lacked a Total Assets field. On the income statement side, the dispersion was even greater, with Total Revenue, Operating Income and Net Income often unavailable.

Finding data for the latest period also proved challenging. XBRL files can contain numerous contexts. Each context refers to a reporting period (e.g., a particular quarter or year) and a scope – which may be the parent company or a particular segment of the corporation (e.g., a subsidiary). Contexts contain period elements and an optional segment element indicating which timeframe and what scope the context covers. To find the latest year’s parent company data, it is necessary to develop a program to walk through each context.

These examples suggest that processing SEC mandated XBRL disclosures is less than straightforward. Indeed, the industry group XBRL.US reports finding 1.4 million errors in the universe of XBRL documents filed thus far.

A recent letter from Darrel Issa (R-CA) to the SEC notes that the agency itself is not using the XBRL files it requires corporations to file. Instead, it continues to rely on commercial data aggregators. Electronic disclosure won’t improve unless numerous eyes are scrutinizing it and reporting issues. Data sets need to be exercised; otherwise they remain unfit.

The lack of XBRL utilization represents a major threat for transparency advocates. If we ask for more accessible disclosures and then don’t use them, filers can be expected to push back. In the case of SEC XBRL, the filings are sufficiently complex to require the use of third party XBRL submission firms. In other words, it is too difficult for most companies to prepare XBRL submissions themselves – they need to use an independent preparer, just as individuals often need to hire professionals to file their annual tax returns. Corporations would undoubtedly like to economize on this cost, and can be expected to resist the XBRL reporting requirement if the filings are not used.

From my perspective, a big problem with the XBRL rollout is that it started with large public companies. By 2009, many data aggregators already had mature processes for assimilating the traditional SEC disclosure. As a result, fielded public company financial data has become a commodity; individuals can access these data for free at Yahoo Finance and many other portals. The incentive for aggregators to use XBRL is thus limited because the problem has already been solved at some level, and because the data are widely available, there is little benefit to potential new entrants.

XBRL can provide much greater benefits for data sets that have not received as much attention. I became interested in XBRL back in 2001 because I was hoping to get a standard source of private company data at my bank. The idea was to provide unlisted corporate borrowers with an XBRL template to provide quarterly disclosure.

Another high impact application for XBRL is state and local government financial reporting. When XBRL was growing up in the 1990s and 2000s, US municipal bonds were generally perceived to be safe. That perception started to change in 2008 with Vallejo’s bankruptcy filing and the collapse of the municipal bond insurance industry. Subsequent municipal bankruptcies culminating with that of Detroit in 2013, have reinforced the perception that municipal securities are risky. Government financial statements, which may have been ignored previously, now have significance as investors search for the next bankruptcy candidates.

However, the rollout of XBRL to other areas – such as local government – may now depend on its successful implementation in existing areas: especially the high profile SEC US public company application. If the SEC is unwilling or unable to engage, the community would be well served by collaborating to implement its own improvements. Although XBRL filing companies compete with one another, they all have an interest in the success of the XBRL standard. Thus, as an industry group, these companies can propose and implement improvements to SEC XBRL filings that will make them easier to use. For example, they can develop an enhanced XML Schema Definition which provides additional checks over and above those legally mandated. Such a schema should ensure that filers always include common financial statements such as Total Assets and Total Liabilities. It should also ensure that, within any given XBRL file, the latest period’s parent company filing is easily identified.

XBRL was and remains a good idea. Transparency advocates need to ensure that it does not become an idea whose time has come and gone. To keep XBRL on track, its public company instance needs to be refined so that implementation costs are reduced. Further, it needs to be applied to other areas – such as US local governments – which stand to gain greater benefits from its adoption.

Tuesday, December 3, 2013

For Puerto Rico, Low Transparency ==> High Yields

Puerto Rico 10-year bonds have been yielding around 8% in recent weeks. That’s a 400bp premium over bonds over AAA munis and 500bp over Treasuries – for instruments that are triple tax free throughout the US.

Muni market headlines focus on the Commonwealth’s large debt (over 100% by some measures), underfunded pensions and weak economic performance. Yet revenues are rising, the largest pension system has been reformed and the Commonwealth has enough cash on hand to avoid issuing any new GO debt for the remainder of Fiscal 2014.

Perhaps Puerto Rico’s risk is not as great as the 8% bond yields suggest. I say perhaps, because gaps in the Commonwealth’s disclosure make risk assessment and monitoring challenging.

Earlier this year, I built a fiscal model for Illinois that suggested the state’s absolute credit risk was limited. The model estimated the probability that interest and pension costs – two large uncontrollable, senior obligations – would claim 30% of state revenues – a level associated with previous defaults in US states and comparable jurisdictions. The state of Illinois supports modeling of this sort by providing a comprehensive annual financial report, interim financial reporting, a multi-year budget forecast and pension system actuarial reports that forecast contributions, benefit levels and other indicators over the next thirty years.


Puerto Rico provides some of these elements, but many aspects of the Commonwealth’s fiscal disclosure are missing, delayed or incomplete.

For example, the Commonwealth’s 2012 CAFR appeared on September 16, 2013 – more than 14 months after the end of the fiscal year. This is later than every US state, and substantially later than most.

Although it takes time to produce audited financials, unaudited cash statements should be easy to generate shortly after the fiscal year end. Yet, as of early December, a statement of fiscal 2013 full year revenues and expenditures by category was still unavailable (see for where the report is supposed to appear). Since the fiscal year ended on June 30, prospective investors have now been waiting over five months for this statement. The Puerto Rico Treasury Department likely has this data: components have appeared in press releases and Treasury has already published comparable numbers for the first quarter of fiscal 2014.

Another shortcoming is the lack of a multi-year revenue and expenditure forecast. Illinois provides a three year general fund revenue forecast as part of its budget package. I have found no comparable report for Puerto Rico.

Finally, the Commonwealth’s pension reporting is relatively skimpy and has been rendered obsolete by the 2013 reform. There is no document that provides up-to-date forecasts of annual employer contributions, employee contributions, benefit levels, administrative expenses or asset valuations.

Thus, Puerto Rico asks investors to lend it money on a long-term basis but fails to provide them the tools necessary to readily forecast the Commonwealth’s ability to service these debts. The resulting uncertainty may well be feeding the frenzied selling that has recently taken Puerto Rico spreads to astronomical levels.

The current administration has been trying to step up its investor relations. There are investor calls, slide presentations and even a voluminous Commonwealth report. But the volume of interaction is a poor substitute for quality, consistency, and predictability – at least for those in the bond markets.

Rather than providing reams of assertions and stale data, the Commonwealth would do well to provide investors and other stakeholders, concise, timely and complete financial statements and projections. It’s the provision of the expected, necessary, transparency that could yield lower yields.

Wednesday, November 20, 2013

The JPMorgan Settlement

Following on from our prior RMBS litigation coverage (FHFA RMBS Litigation Totals and A Proliferating "Putback" Problemo) we wanted to add some color to the recent $13bn settlement by JPMorgan.

Initial settlement details:
  1. JPMorgan may not pursue indemnification claims from the FDIC for any matters covered by the settlement. 
  2. Included in the settlement is the $4 billion FHFA settlement regarding private-label RMBS losses ($1.26 billion to Fannie Mae; $2.74 billion to Freddie Mac). 
  3. Previously mentioned $680mm and $480mm rep & warranty settlements with Fannie Mae and Freddie Mac, respectively, are not included in this agreement. (This leaves open the possibility for JPM to claim that the FDIC is responsible for WaMu originations in the rep & warranty settlement.) This could impact the net result of Deutsche Bank National Trust Co. v. Federal Deposit Insurance Corp. et al. 
  4. Criminal probe is not closed. 
  5. Acknowledgment of misrepresentation, but no explicit admission of wrongdoing.
Our additions are in blue within the table. Sources are at the end.


Friday, November 8, 2013

Californian (Local) Govt. Credit Scoring, Enhanced

Earlier this year, we launched a web site containing financial data and credit scores for 260 California cities

Thanks to a recent grant from the Sunlight Foundation, we have extended the site to also cover 55 California counties. The enhanced site is now available at

The research behind the scoring model can be found at:

It's detailed and colorful. Check it out and tell us what you think!

Friday, November 1, 2013

FHFA RMBS Litigation Totals

From complaints (and amended complaints) and settlements we were able to string together this table of potential litigation costs that may be be borne by some of the major financial institutions who sold RMBS securities to FHFA -- based on a basic extrapolation of settlement expenses from the two data points that have been disclosed.  

This covers only RMBS purchase litigation -- not the mortgage repurchases, or "put-backs."  The totals potentially due to FHFA, on behalf of Fannie and Freddie, also ignore any potential settlements the FHFA might strike with other parties which they have not sued, like Wells Fargo. Numbers in the right-hand columns are in billions.

Monday, September 30, 2013

Bill Gross and Moody's US Ratings

Last week, Bill Gross sent a tweet suggesting that investors should not trust Moody’s US sovereign rating. Given my own concerns about biases in sovereign ratings generally and a review of recent Moody’s pronouncements on US debt, I think Gross has a valid point.

On July 18, the agency affirmed America’s Aaa rating and raised its outlook from negative to stable. The timing of Moody’s action looks a bit odd in an environment of budget gridlock and threats of default if Congress fails to raise the debt ceiling. In 2011, US credit downgrades were sometimes justified in terms of political dysfunction. Since ongoing deficits will necessitate further debt ceiling hikes in coming years and we continue to face a Cold War style domestic political environment, future drama is all but inevitable. Stable, triple-A sovereigns are not supposed to be a source of drama.

Back on July 13, 2011, Moody’s placed the US rating on review for downgrade “given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on US Treasury debt obligations.” We are now in the same situation, yet Moody’s has not initiated any sort of review. Worse, on September 11, 2012, Moody’s wrote the following about its plans for the 2013 debt ceiling debate: “the government's rating would likely be placed under review after the debt limit is reached but several weeks before the exhaustion of the Treasury's resources.” This is where we are now, so what happened to the review?

After the 2011 debt ceiling increase, Moody’s affirmed its Aaa rating but assigned a negative outlook to US sovereign credit. It gave four conditions that could trigger an eventual downgrade, one of which was the failure to adopt further fiscal consolidation measures in 2013. No such measures have been adopted this year, nor are any feasible in the current political climate. We did see a resolution to the fiscal cliff debate back in January, but that was not a fiscal consolidation measure. Had nothing been done in January, all of the Bush era tax cuts would have expired. Instead, these cuts were made permanent for 99% of Americans at an estimated ten year cost of $3.6 trillion.

In its September 11, 2012 update, Moody’s conditioned the country’s Aaa rating on the adoption of “specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term.” In lay terms, Moody’s was asking for a grand bargain which would address taxes and entitlement reform. But, as we all know, there has been no grand bargain nor is it reasonable to expect one until 2015 at the earliest.

Based on Moody’s 2011 and 2012 pronouncements, it is hard to justify the agency’s July 2013 action. Moody’s rationalized it on the grounds that “the US government's debt-to-GDP ratio through 2018 will demonstrate a more pronounced decline than Moody's had anticipated when it assigned the negative outlook”. 

Since Moody’s appears to rely on CBO numbers, it is worth checking this contention against changes in the CBO budget baseline. In August 2011, CBO’s baseline budget projection called for a 65.2% debt to GDP ratio in 2018. The latest CBO forecast estimates a 68.4% ratio in 2018. So things actually look worse in 2018 than originally anticipated, yet Moody’s reaction is an upgraded credit outlook.

So we now see the basis for Bill Gross’ tweet. Moody’s pronouncements on US debt are inconsistent and thus not useful to the investment community. Changes in the rating stance do not appear to have a basis in policy; instead they seem to portray a reluctance to offend the federal government. 

From the perspective of Moody’s shareholders, however, this may be a wise approach: given S&P’s claim that the federal lawsuit it faces was payback for its having downgraded the US debt, Moody’s shareholders may (rightly or wrongly) be fearful that their stock would lose value should Moody’s downgrade the US. Bill Gross may be saying that the presence of such a conflict can undermine any hopes for independence or integrity in the ratings process.

Friday, September 27, 2013

In Trust, We Trust

PIMCO's Bill Gross put out a curious statement on his Twitter account on Wednesday.

A company spokesperson reportedly told media outlets that Gross' remark was in regards sovereign credit ratings, not necessarily all credit ratings. 

No support is given for either claim - that Moody's and the US Treasury are in cahoots, or that we can trust S&P, Fitch and Egan Jones as alternative providers. 

Why So Curious? 

What's also got to be at least mildly interesting is that if his comment isn't investment advice, it must be close to it: he's suggesting whose credit opinions are trustworthy (or reliable?) and can be taken into account when considering an investment. Given there's no substantiation for his claims, different from a developed theory, he's saying: "trust me, you can trust these guys."  Is he putting his name or rep behind the future performance of sovereign ratings issued by these three companies? 

And of course, we're all clinching our seats in anticipation: Does PIMCO have proof that it hasn't yet shared, either of Moody's-Treasury collusion or that S&P's, Fitch's, and Egan-Jones' (sovereign) ratings are all trustworthy?  These claims should be "provable" after all, shouldn't they? 

We'll let you know if we find out. 

In the meantime, perhaps this speaks to the development of at least one positive trend: that investors will be encouraged to differentiate between and among the rating agencies - preferably not purely on Bill Gross' say-so, but maybe on performance. Rating agency ABC has a more formidable methodology over here, whereas rating agency DEF's ratings hold greater predictive content over there. 

If no differentiation is made by investors, rating agencies will have few reasons to spend moneys improving their systems, or turn away business in a fight for higher standards or increased accuracy.

Tuesday, September 17, 2013

Crystal-Clear Country Ratings

If you're one for ratings transparency, you'll be somewhat enthusiastic about Moody's changes to their methodology for rating sovereign debt.

Moody's previous methodology was more of a framework -- there were no "numbers" for the mathematicians among us.
Aa credits had – "Very high economic, institutional or government financial strength and no material medium-term repayment concern."
A credits exhibited – "High economic, financial or institutional strength and no material medium-term repayment concern."
The new methodology provides significant mathematical guidance for those looking to independently verify what a country's rating ought to be, either to prepare for an upgrade or downgrade, or to begin the ratings process for an unrated sovereignty.

It looks like Moody's has taken the stance that their ratings process should be somewhat visible, or "reversible."  The language, too, has changed from their methodology of 2008 to their September 2013 release.

The old methodology held that (emphasis added): 
"There is no adequate model for capturing the complex web of factors that lead a government to default on its debt. Rating sovereign entities involves an unusual combination of quantitative and qualitative factors whose interaction is often difficult to predict." ... "a mechanistic approach based on quantitative factors will be unable to capture the complexity of the interaction between political, economic, financial and social factors that define the degree of danger, for creditors, of a sovereign credit. ... This [ratings methodology's] step by step approach produces a narrow rating range. In some instances, however, the final rating may diverge from the range – in other words, the unusual characteristics of a sovereign credit may not be fully captured by the approach.
Moody's new methodology offers to provide more than a road-map (emphasis added):
"The aim of this methodology is to enable issuers, investors and other interested market participants to understand how Moody’s assesses credit risk in this sector, and explain how key quantitative and qualitative risk factors map to specific rating outcomes. Our objective is for users to be able to estimate the likely credit rating for a sovereign within a three notch alpha-numeric rating range in most cases."
Importantly, the new methodology affords Moody's analysts some (possibly substantial) flexibility when applying its model, in the form of what they call in-model "adjustment factors."  If properly applied, the adjustment factors can allow analysts room to maneuver to the extent the pure mathematical model alone isn't capturing the risk they're identifying. (As an aside, we would recommend investors push for adjustment factors to be disclosed, so that they cannot be arbitrarily influenced to suit an analyst's opinion: if they can be changed to produce a pre-defined rating expectation, it becomes questionable what the point is of having the model!)

The implementation of the adjustment factors is, unfortunately, not well-defined in any sense.  If, how and when they will be enforced is somewhat unclear -- and the magnitude of their impact is only partially developed, with the implementation and effect of the "diversification" adjustment factor being especially vague:
"This ‘credit boom’ adjustment factor can only lower the overall assessment of the sovereign’s Economic Strength. For most countries, the ‘credit boom’ risk will be Very Low or Low; in these cases, the ‘credit boom’ adjustment factor will be neutral for the assessment of Economic Strength. However, when the combination of the probability of excessive credit growth and its severity lead to a Medium, High or Very High score, this can result in the assessment of Economic Strength being lowered by between one and six scores in the 15-notch Factor 1 score (which translates into a lowering by up to two rating notches). Additional adjustment factors may be considered in the assessment of Economic Strength if deemed appropriate.

Second, the ‘diversification’ adjustment factor allows for the shock absorption capacities afforded by a developed country’s degree of economic diversification and flexibility to lift its overall assessment by one score. We determine the potential for such an adjustment based on the distribution of different sectors’ gross value added in the economy’s annual output. The ‘diversification’ adjustment factor can also lower the overall assessment of a sovereign’s Economic Strength, if, for example, a country is significantly reliant on a single industry or commodity.

Additional adjustment factors may be considered in our assessment of Economic Strength over time if we find that another indicator can provide a universally high degree of explanatory value for Economic Strength." (emphasis added)
While the new methodology doesn't look likely to meet its objective of allowing a market participant to predict a rating "within a three notch alpha-numeric rating range," it must be considered a step in the right direction, at least for those seeking ratings transparency.


Reference Documents (may require Moody's log-in):

2013 Methodology
Associated Document -- Refinements to the Sovereign Bond Rating Methodology
2008 Methodology

Thursday, August 22, 2013

A Proliferating "Putback" Problemo

Several media outlets have focused of late on the ongoing litigation costs being incurred by JPMorgan (and suffered by its shareholders) pertaining to crisis-era loans and structured products, and post-crisis concerns, like investigations into the "London Whale" trade and allegations into potential manipulations of LIBOR and the energy market manipulations.  (See for example the FT's "JPMorgan pledges to clean up legal woes.")

We're closing in on 5 years since Lehman filed for bankruptcy protection but, of course, the problematic mortgage loans originated between 2005 and 2008 haven't completely left the system.  In some ways the problems they're causing the banks are increasing.  We'll explore the headaches one particular aspect – mortgage repurchases – could be causing at Deutsche Bank, and how a couple of recent court rulings could exacerbate the pain.

The WSJ recently reported "Deutsche Bank Net Profit Halves on Charge for Potential Legal Costs." After absorbing the charge, the Journal reports, Deutsche Bank had litigation reserves of EUR 3.0 billion; as of June-end, DB had cordoned off $534 million in provisions against outstanding mortgage repurchase demands - or "putbacks."

We went back and took a look at DB's reserves historical against put-backs.  Since year-end, they have increased their reserves roughly 20%, from EUR 341 mm to $534 mm (applying a 1.3x exchange rate from EUR to USD at both year-end '12 and mid-year '13).  These are provisions against outstanding demands that grew roughly 28% from $4.6 bn as of YE to $5.9 bn as of June-end.

Will repurchase demands continue to grow, requiring the posting of additional reserves?

First, let's discuss mortgage put-backs.

Mortgage Put-backs

According to Deutsche, from 2005 through 2008, as part of its U.S. residential mortgage loan business, it sold "approximately U.S. $ 84 billion of private label securities and U.S. $ 71 billion of loans through whole loan sales, including to U.S. government-sponsored entities such as the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association."

To keep this simple, Deutsche essentially sells or transfers or conveys residential mortgages into securitization vehicles, or trusts: it "puts" them into the trust.  Thousands of loans can be transferred or deposited into a single trust. If any of the loans is later found to be, let's say, problematic, or in violation of agreed-upon representations made, a trust's trustee would ideally be able to put 'em back to Deutsche at cost: the "put-back". (Keep in mind that DB may not have made representations on all of the loans transferred into trust vehicles for which DB acted as the securitization sponsor.)

In DB's words now, "Deutsche Bank has been presented with demands to repurchase loans or indemnify purchasers, other investors or financial insurers with respect to losses allegedly caused by material breaches of representations and warranties. Deutsche Bank’s general practice is to process valid repurchase demands that are presented in compliance with contractual rights. Where Deutsche Bank believes no such valid basis for repurchase demands exists, Deutsche Bank rejects them." (emphasis added)

Importantly, two parties don't always agree with the validity of a repurchase request.  The question becomes, then, whether DB's disclosed $5.9 billion of repurchase demands outstanding constitute those that are "agreeable" to Deutsche, or whether DB might reject some of them?  And if they are all agreeable, how large is DB's exposure to other repurchase demands that it has previously rejected, but that may become contentious or the subject of litigation.

We can't be sure, but we do know that DB's disclosure changed in this regard between Sept-end 2012 and YE 2012.

From: "As of September 30, 2012, Deutsche Bank has approximately U.S. $ 3.3 billion of outstanding mortgage repurchase demands (based on original principal balance of the loans and excluding demands rejected by Deutsche Bank)." (emphasis added)

To: "As of December 31, 2012, Deutsche Bank has approximately U.S. $ 4.6 billion of outstanding mortgage repurchase demands (based on original principal balance of the loans)."

Since then the description hasn't changed. In their YE earnings call transcript, they mention there having been an increase from $3.3bn to $4.6bn, "attributable to demands made by RMBS investors." This seems to suggest that the change in description is incidental to, rather than the cause of, the increase.

They also intimate on the call that the improving market conditions – probably home prices – understandably translate into lower losses on the repurchased loans.  Could this be one reason why the repurchase demands are growing or outpacing settlements – or that Deutsche is postponing, slowing, or opting against the repurchase or settlement of these loans, as indicated by the slow growth in the third row of the table?

Mortgage Put-back Litigation 

As mentioned above, parties don't always agree as to the viability of a put-back claim.  Deutsche Bank unit DB Structured Products is on the receiving end of a number of lawsuits in which indenture trustees, on behalf of the mortgage-backed securities trusts themselves, claim that DBSP has failed to repurchase some or all of the violating loans presented to them.

Last week, District Judge Harold Baer added to a recent string of decisions in favor of securitization trusts’ ability to “put-back” non-complying mortgage loans to the conveyor – in that instance UBS Real Estate Securities Inc. (“UBS”).  Like many related complaints, the argument was that UBS had breached its contractual obligation under the relevant Pooling and Servicing Agreements (“PSAs”) to repurchase certain mortgage loans that did not conform to its representations and warranties.

In denying UBS’ motion to dismiss the case, Judge Baer explicitly disagreed with an earlier decision, more favorable to the defendants, made by US District Judge John Tunheim in MASTR Asset Backed Sec. Trust 2006-HE3 ex rel. U.S. Bank Nat. Ass'n v. WMC Mortgage Corp. – taking rather the stance consistent with a 2002 First Circuit decision and referencing other recent decisions more favorable to trust investors, including that of Judge Rakoff in Assured Guar. Mun. Corp. v. Flagstar Bank, FSB, No. 11 Civ. 2375.

One such matter of Deutsche's, before Justice Kornreich of the Supreme Court of the State of New York, concerns a trust that originally contained 8,815 home loans, according to the complaint.  The trustee-plaintiff put forward in the complaint that "[in] total, 1,642 repurchase demands have been submitted to DBSP thus far," and contended that "[the] Trust has suffered over $330 million of losses on non-performing Mortgage Loans to date, and will continue to suffer damages as a result of DBSP’s failure and refusal to comply with its express contractual obligations."

According to the complaint, a significant portion of mortgage loans tested has failed to comply with the representations made:
"A loan-level investigation performed by an independent forensic mortgage loan review firm (the “Forensic Review Firm”) has, thus far, revealed breaches of the Representations and Warranties with respect to 696 Mortgage Loans in the Trust out of the 697 Mortgage Loan files that were analyzed. Furthermore, an analysis of publicly-available data regarding the Mortgage Loans in the Trust uncovered breaches of the Representations and Warranties with respect to 946 Mortgage Loans."
In mid-May 2013, Justice Kornreich decided to let the case continue, denying defendant DBSP's motion to dismiss the complaint.  ACE Securities Corp. v. DB Structured Products, 650980/2012, NYLJ 1202604071610, at *1 (Sup., NY, Decided May 13, 2013).

Our investigation came up with 17 such unique, current, put-back lawsuits filed against DB Structured Products since March of last year (and there may well be others) by trusts holding an aggregate of roughly $15bn in loans at origination. (In some of the cases, parties other than the trustee have sued DB Structured Products, purportedly on behalf of the trust or trustee.)

The trusts have since declined in size, but it is worth noting that even some loans backed by homes which have foreclosed upon, may still be put-back to the transferor: in this case DB Structured Products. Justice Kornreich maintained that DBSP ought still be responsible for repurchasing such non-complying loans, finding the defendant's argument to be, in her words, "unconvincing." 
"If DBSP were correct, it would be perversely incentivized to fill the Trust with junk mortgages that would expeditiously default so that they could be Released, Charged Off, or Liquidated before a repurchase claim is made. Indeed, if DBSP learned that loans were non-conforming and played a crafty game of accounting by moving them off the Trust's books to their own to evade their repurchase obligations, such actions would be a breach of the duty of good faith and fair dealing. Consequently, it is to no avail to contend that the nonconforming loans are long gone and the Trustee's repurchase rights have been extinguished by DBSP's actions."

Thursday, August 15, 2013

Richmond's Million Dollar Eminent Domain Homes

Three of the mortgages Richmond, California is threatening to acquire through eminent domain have balances in excess of $880,000 - suggesting that the underlying properties were worth over $1 million at the peak of the housing boom. Public records show that two of the three properties did, in fact, change hands at prices in excess of $1 million several years ago. (On the 624 loans up for acquisition, the median and average outstanding balances are roughly $380,000.)

The three homes are all in the tony Point Richmond neighborhood. The accompanying picture, taken from Google maps, shows the house carrying the third largest mortgage in the eminent domain pool. The other two homes were apparently too far back from the road for Google’s van to photograph.

The biggest mortgage, with a balance of slightly over $1.1 million, is on a property that sold for $1.4 million in 2001 - well before the housing boom crested in 2006. The property currently has an assessed value of about $750,000 and Richmond is proposing to buy the mortgage for $680,000. The three bedroom waterfront home is 2500 square feet and sits on a 17,000 square foot lot - quite large by San Francisco Bay Area standards.

While this particular homeowner appears to be underwater, appraisals for such unique homes are prone to both error and volatility given the lack of recent comparables. Thus, the city’s “offer” to mortgage backed security holders may be significantly less than the homeowner could receive on the open market.

More importantly, the fact that such expensive homes are included in Richmond’s eminent domain initiative raises the question of what public interest is being served. Point Richmond is not a blighted neighborhood and any foreclosed home would likely sell very quickly. Further, anyone in a million dollar home is probably not poor - at least not by any conventional definition of the word poor.

Proponents of the use of eminent domain to resolve underwater mortgages see this as a way for the little guy to “take it” to Wall Street. While it is true that Wall Street made substantial profits packaging up pools of dodgy mortgages, Richmond’s action does not address that injustice. Those profits have already been taken: what remains are mortgage borrowers and MBS investors, many of whom are public employee pension funds.

So the question really is: Should the city of Richmond use eminent domain to transfer wealth from public employees (and the taxpayers that fund their pensions) to affluent homeowners who took on more mortgage debt than they should have?

For an update on this, visit the Wall Street Journal's coverage or the San Francisco Chronicle's coverage.

Tuesday, August 6, 2013

Are Moody's and S&P Growing Apart?

Leading up to the November 2012 announcement that McGraw Hill would sell its education division – and become more of a rating agency/financial institution like Moody's Corp. – the two companies' stocks moved in tandem, with a correlation of over 90%. Since then, the correlation has gone way down, into the 70-80% region.

Thursday, June 20, 2013

AAAs still Junk -- in 2013!

Breaking news: Several securities, boasting ratings higher than France and Britain as of two weeks ago, are now thought quite likely to default.

Moody's changed its opinion on a number of residential mortgage-backed securities (RMBS), with about 13 of them being downgraded from Aaa to Caa1.

The explanation provided: "Today's rating action concludes the review actions announced in March 2013 relating to the existence of errors in the Structured Finance Workstation (SFW) cash flow models used in rating these transactions. The rating action also reflects recent performance of the underlying pools and Moody's updated expected losses on the pools."

In short: the model was wrong - oops!  ($1.5bn, yes that's billion, in securities were affected by the announced ratings change, with the vast majority being downgraded.)

Okay, so everybody gets it wrong some time or other.  What's the big deal?  The answer is there's no big deal.  You probably won't hear a squirmish about this - nothing in the papers.  Life will go on.  The collection of annual monitoring fees on the deal will continue unabated and no previously undeserved fees will be returned. Some investors may be a little annoyed at the sudden, shock movement, but so what, right?  They should have modeled this anyway, they might be told, and should not be relying on the rating.  (But why are they paying, out of the deal's proceeds, for rating agencies to monitor the deals' ratings?)

What is almost interesting (again no big deal) is that these erroneously modeled deals were rated between 2004 and 2007.  So roughly six or more years ago.  And for the most part, if not always, their rating has been verified or revisited at several junctures since the initial "mis-modeled" rating was provided.  How does that happen without the model being validated?

A little more interesting is that in many or most cases, Fitch and S&P had already downgraded these same securities to CCC or even C levels, years ago!  So the warning was out there.  One rating agency says triple A; the other(s) have it deep in "junk" territory.  Worth checking the model?  Sadly not - it's probably not "worth" checking.  This, finally, is our point: absent a reputational model to differentiate among the players in the ratings oligopoly, the existing raters have no incentive to check their work. There's no "payment" for checking, or for being accurate.

Rather, it pays to leave the skeletons buried for as long as possible.


For more on rating agencies disagreeing on credit ratings by wide differentials, click here.
For more on model risk or model error, click here.

Snapshot of certain affected securities (data from Bloomberg)

Monday, June 17, 2013

Outdated Ratings

Two Bloomberg reporters wrote a thought-provoking piece late last week (see Lost AAA Brings Falling Yields-to-Deficits on Downgrade) on the forthcoming ratings downgrade for the US.  In some ways they explore the age-old question of the (odd) relationship between a ratings change and the market price, or yield, of a bond.
"Yields on Treasuries are lower, the dollar is stronger and the S&P 500 Index (SPX) of stocks reached a record high since Aug. 5, 2011, when S&P said the U.S. was less creditworthy than Luxembourg and 17 other sovereigns."

But their article really tests the case of whether a US downgrade can be implemented despite an improving economic picture.
"... the unemployment rate has fallen, household wealth has reached a record and the budget deficit is shrinking. More downgrades may be coming, anyway."

Stepping back, it's fair to debate whether the economy is in better shape.  There are likely economists on both sides of the table on this one.  And certainly the statement that "the budget deficit is shrinking," if read on its own, can be misleading: the estimated budget deficit this year is expected to be lower than that of last year, but the overall federal deficit is expected to increase (or in more proper US fiscal parlance, the debt is expected to increase).

According to the Bloomberg article, "Moody’s Investors Service said it’s awaiting lawmakers’ budget decisions this year as it weighs reducing America’s Aaa."

But given the US GDP is growing, while Europe is in a recession, can it make any sense to downgrade the US?  Remember, the rating agencies claim their ratings are RELATIVE measures of risk.  In other words, the rating agencies are ranking each country relative to other countries.  So for the US to be downgraded, it would need to be getting worse relative to its competition.

Our guess is that what's happening here is the result of a fair share of awkwardness surrounding a situation in which many of the rating agencies' outstanding ratings may not reflect their current opinions.  If they delayed implementing the downgrade since the US first failed to meet the relevant criteria necessary to maintain the AAA rating, they would now look a little silly downgrading so long after the fact, now that the economy has stabilized, or turned the corner.

According to the article, "Fitch Ratings, which has a “negative” outlook on the U.S., said in February that the debt trajectory isn’t consistent with a AAA borrower."  Even if you agree with Fitch on this, okay, the US may still not be back at AAA if the rating agencies were to strictly adopt their criteria. But, as the Bloomberg article forces us to ask, how can a downgrade be appropriate now?

Tuesday, June 11, 2013

There's Always a Model

Opponents of quantitative credit models and their use in bond ratings contend that the decision to default is a human choice that does not lend itself to computer modeling. These critics often fail to realize that the vast majority of ratings decisions are already model-driven.

Recently, Illinois’ legislature failed to pass a pension reform measure. Two of the three largest rating agencies downgraded the state’s bonds citing leadership’s inability to shrink a large unfunded actuarial liability. The downgrades were a product of a mental model that connects political inaction on pensions to greater credit risk.

Indeed most rating actions and credit decisions are generally supported by some statement of a cause and effect relationship. Drawing a correlation between some independent driver – like greater debt, less revenue or political inaction – and the likelihood of default is an act of modeling. After all, a model is just a set of hypothesized relationships between independent and dependent variables. So ratings analysts use models – they just don’t always realize it.

The failure to make models explicit and commit them to computer code leads to imprecision. Going back to the Illinois situation, we can certainly agree that the legislature’s failure to reform public employee pensions is a (credit) negative, but how do we know that it is a negative sufficient to merit a downgrade?

In the absence of an explicit model, we cannot. Indeed, the ratings status quo has a couple of limitations that hinder analysts from properly evaluating the bad news.

First, ratings categories have no clear definition in terms of default probability or expected loss, so we don’t know what threshold needs to be surpassed to trigger a downgrade.

Second, in the absence of an explicit model, it is not clear how to weigh the bad news against other factors. For example, most states, including Illinois, have been experiencing rapid revenue growth in the current fiscal year. Does this partially or fully offset the political shortcomings? And, all other things equal, how much does the legislature’s inaction affect Illinois’ default risk.

In the absence of an explicit model, analysts make these calculations in an intuitive manner, creating opportunities for error and bias. For example, a politically conservative analyst who dislikes public pensions may overestimate their impact on the state’s willingness and ability to service its bonds. Likewise, a liberal sympathetic to pensions may underestimate it.

A news-driven downgrade like the one we saw last week may also be the result of recency bias, in which human observers place too much emphasis on recent events when predicting the future. Worst of all, an implicit mental model can easily be contaminated by commercial considerations unrelated to credit risk: what will my boss think of this proposed downgrade, or how will the issuer react? In an ideal world, these considerations would not impact the rating decision, but it is very difficult for us mortals to compartmentalize such information. Developing and implementing a computer rating model forces an analyst to explicitly list and weight all the independent variables that affect default risk.

Computer models are also subject to bias, but they provide mechanisms for minimizing it. First, the process of listing and weighting variables can lead the analyst to identify and correct her prejudices. Second, to the extent that the model is shared with other analysts, more eyes are available to find, debate and potentially eliminate biases.

Once the model is in place, news developments can be tackled and analyzed without recency effects. In the case of Illinois pensions, the legislative development would have to be translated into an annuity of expected future state pension costs (or a distribution of same) so that it can be analyzed with reference to the state’s other fiscal characteristics.

Computerized rating models – like any human construction – are subject to error. But the process of developing, debating and iterating explicit models tends to mitigate this error. We all apply models to credit anyway; why not just admit it and do it properly?

Monday, May 13, 2013

An Open Source Alternative to No Bid Contracts

At Muniland, Cate Long reports that the US Treasury Department’s Office of the Comptroller of the Currency (OCC) awarded Municipal Market Advisors (MMA) a contract to evaluate the risk of municipal bond holdings by banks it regulates.  OCC did not find any credible alternatives and thus is awarding the contract to MMA on a no-bid basis.  Quoting at length from Cate’s excellent blog post:
So federal regulators, who can no longer use credit ratings for evaluations of the municipal bond holdings of the commercial banks that they regulate, just gave a no bid contract to MMA, a relatively small firm with four principals. In essence the OCC will be substituting the opinions of MMA for those of the credit ratings agencies. Federally chartered banks held $363 billion of municipal securities as of 4th quarter 2012 according to the Federal Reserve ... The federal bank regulator will essentially be substituting the work of credit rating agencies, which issue over 1 million individual municipal ratings, with “research” from a small private shop. Is this wise? I think restricting themselves to such limited information is short-sighted given that muniland has over 80,000 issuers with $3.7 trillion of municipal debt outstanding. High quality credit analysis for even the debt of 50 states requires a shop bigger than MMA. Let alone all the other issuers. … Of course all the folks at MMA are nice, informed market professionals. But this process of hiring independent municipal research is ridiculous. No bid contracts have no place in our new, more transparent, post Dodd-Frank regulatory framework. The municipal bond market is facing its toughest challenges since the Great Depression and this BPD/OCC process needs more public input and openness.
As I will discuss at Tuesday’s SEC Credit Ratings Roundtable, there is a better alternative to this kind of arrangement. For almost 50 years, academics have been churning out corporate default models.  This modeling effort could be extended to structured and government bonds.  If the modeling data and software were fully open, these academic tools could undergo rapid, iterative improvements through a process of mass collaboration:  like Wikipedia or Linux.  If the SEC were to create a standards board for open source credit models, a group of experts would be empowered to separate the wheat from the chaff among these open source products. Regulators could further encourage the development of such tools by allowing results of certified models to be used in lieu of ratings as a credit-worthiness standard – meeting the spirit of Dodd-Frank Section 939A.  I make this argument at greater length here.
What should supplement or replace ratings?  Confidential, non-reproducible findings from a proprietary vendor, or transparent tools developed using academic research protocols and benefiting from peer review? I think the answer is clear.

Monday, April 8, 2013

Dispelling a Myth or Two about the Ratings Lawsuits

Since the Justice Department sued S&P for fraud in February, the media has been awash with concerns as to whether a lawsuit against Moody's will inevitably follow - and questions about the lack of a lawsuit against Moody's pointing to the potential for bias on the side of the DOJ.  The inference drawn was that the DOJ might be targeting S&P because S&P downgraded the debt of the United States.

Meanwhile, market participants and researchers have honed in on the fact that other credit rating agencies issued “virtually identical” grades on the same securities that lie at the heart of the lawsuit.

Commenting on the fact that S&P alone has been sued (at this stage) by the DOJ, a member of S&P's general counsel reportedly remarked “The S&P ratings for the CDOs at issue in this lawsuit are identical to the ratings issued by other rating agencies. So we don’t have an explanation and you’ll have to ask the Department of Justice…”

Meanwhile, Edwin Groshans, a managing director, at Washington-based equity research firm Height Analytics LLC, reportedly commented that “Given that the ratings between S&P and Moody’s were identical, a loss by S&P would create significant uncertainty for Moody’s regarding whether the Department of Justice would take action against it also…”

Of course, while these arguments may have been carefully considered, and may even have some rational basis, they are built on a faulty premise.  Let us explain why. 

Straw Man Argument

The key distinction is that the DOJ is not suing for fraud in the rating provided.  The DOJ isn't saying the rating was wrong or imprecise or otherwise lacking in predictive content. Therefore, that Moody's provided the same or an equivalent rating has no import.

The DOJ is saying that in the context of these securities, it is concerned that S&P maneuvered its ratings process, in a manner neither objective nor unbiased, to achieve a necessary result (including the generation or maintenance of revenues).  As such, if Moody's already had achieved THAT result based on its then-current methodology, it would not have had to maneuver towards it.  No foul committed.

In the case of active ratings competition, it is often (but not always) the case that any jockeying done is done (or needs to be done) by the more severe rating agency/agencies, so as to allow them to compete with other raters who have a rosier view. 

An Example

Suppose we have a world with only 3 rating agencies – Moody's, Fitch and S&P – with two being selected to rate each bond.  If for example Moody's and Fitch were the two raters getting business because their methodologies resulted in the highest rating, S&P alone would have an incentive to maneuver so as to win new business or disrupt status quo.  If they did, and their actions resulted in their achieving the same view as say Moody's, then they may be included on certain deals.  But how does this translate into any misdemeanor on the side of Moody's?

Is S&P is being subjected to special attention, or targeted?  We don't know.  But it has nothing whatever to do with the nature of the lawsuit that, because Moody's may have rated the assets at similar levels, it ought similarly to be accused of improper conduct.

That Moody's achieved a similar rating to S&P does not imply that its ratings process was influenced in a manner similar to that described by the DOJ in its lawsuit against S&P.

It may be the case that in certain scenarios all 3 rating agencies simultaneously, knowingly, intentionally, lowered their ratings standards to compete for the same business, while advertising themselves as being independent investor services.  This is possible - but until that is known to have occurred, any argument suggesting Moody's ought to be similarly defensive to any charges alleged of S&P is, to us, simply an informal fallacy

Friday, March 15, 2013

Are Credit Ratings Opinions?

The Justice Department's lawsuit against S&P made us reconsider whether the ratings provided by S&P were "opinions."

Let's quickly look at the concept of an opinion: one often relates the word "opinion" to a judgment (which may be factually supported) but may not be "provable."  A fact, however, is closer to being provable.

Of course, the rating agencies have long argued that their ratings are opinions, but there's probably more to it than that.

At the very beginning, many rating agencies have the ability (and they exercise it) to assign a rating of "D" to defaulted issuers or assets.  Many (but perhaps not all) issuer or asset defaults, relative to their defined terms, are directly provable - in other words, at least certain ratings may be more fact, and less opinion.

Now let's dig deeper into the DoJ's argument.  One core argument alleged throughout the complaint was that S&P maneuvered its models/methodology to achieve the rating levels desired by the structuring bankers (the issuers).
"As set forth in detail … S&P's competition for ratings business, that is, its desire to maintain and increase market share and profits, and its resulting desire to maintain its relationships with issuers who drove its ratings business, improperly influenced S&P to favor issuers in its ratings of RMBS and CDOs. In particular, as alleged in detail … to maintain and increase its market share and profits, S&P limited, adjusted, and delayed updates to the ratings criteria and analytical models S&P used to assess the credit risks posed by RMBS and CDO tranches, thereby weakening those criteria and models from what S&P analysts believed was necessary to make them more accurate."
The argument could therefore be that the resulting rating wasn't the "opinion" formed as part of the ratings process: the required rating, known upfront, caused the determination as to which ratings process/model to apply.  In such a case, the rating would be the fact, and the process (to be used) is the judgment.

In other words, an argument may be that the resulting ratings were not the result of the ratings process.  The ratings processes used were the result of the rating required!  

(Think of this relative to the structuring process itself, one of the goals of which is to achieve a certain rating.  Thus it may be inferred -- if the DOJ's allegations hold true -- that both the banks and S&P were playing the role of engineering their analyses in such a way as to achieve the desired rating.)

Monday, March 4, 2013

Are the Rating Agencies in Sync?

This morning's Financial Times brought with it another wonderful article by Arturo Cifuentes.  Much of his commentary on ratings reform is not new - but it is important that we be reminded of the distance we have yet to travel.

We're going to examine one element of his piece, an element he has brought up before: the rather peculiar situation of credit rating agencies coming to the same conclusions (i.e., equivalent, mapped ratings) in the structured finance arena, despite the application of different methods and proprietary data (and different rating scales, and having different ratings meanings, but Prof. Cifuentes doesn't mention these here).

Digging a little deeper, we notice similar behavior in other spaces too.  In corporate finance space, Dell Corporation - the maker of laptop computers, among other things - had not had its rating visited by any of the "Big Three" credit rating agencies since 2007.  On February 5, 2013, all three rating agencies downgraded Dell. (See screenshots courtesy of Bloomberg LP.)

Equally interesting, the last time S&P and Fitch analyzed Dell was within a week of one another in August 2007.

Late last month, the Economist ran an article that tried to describe how the rating agencies rate sovereign debt.  What the article did do was show just how similar their opinions are of sovereign countries.

We did a back of the envelope analysis to establish whether they tend to share the same ways of looking at sovereign countries, by converting the ratings to a simple comparable scale, and measuring correlation using the excel function. (Moody's Aaa and S&P or Fitch AAA were all converted to a "21"; Moody's Aa1 and S&P/Fitch's AA+ were converted to a "20" and so on.)

We found the correlation to be extraordinary:

Of course, we're not saying the rating agencies always agree.  We covered in 2011 how in the realm of seasoned structured finance deals, they vary widely in their opinions.  But the concept here may be that there is less pressure to agree once the deal gets done or for securities over which the scrutiny is limited. When they're competing, however, they seem increasingly to agree.

Friday, February 15, 2013

Moody's "Expects" DoJ Lawsuit to Cost S&P Less than $10mm

Wow, we're finally talking "expect[ed] loss."

So here's the theory.  Moody's and Fitch have both been considering downgrading S&P's debt since September 2011.  Apparently there was much uncertainty which has been removed now that a multi-billion-dollar lawsuit has been filed, and both rating agencies have quickly downgraded S&P: Fitch downgraded from A- to BBB+ and Moody's from A3 to Baa2.  (How similar their opinions are!)

It's easier to dig a little deeper on Moody's side -- Moody's rating speaks directly to an expected loss.  

According to Bloomberg data, McGraw Hill has two debt issues outstanding, each for $400mm, with one maturing in 2017 and the other in 2037.  The ratings are identical for each issuance, irrespective of its maturity.

For the 2017 bond, the rating downgrade from A3 to Baa2, maps to an increased expected loss estimate change from approximately  0.3% to roughly 0.66% (using 4-year maturity as an estimate).  The difference is 0.36%, which comes out to about $1.5mm on a $400mm bond.

For the 2037-maturity bond, the downgrade maps to an expected loss estimate that increases to 6.35% from 4.17%  (using 24-year maturity as an estimate).  Even that's not too much - roughly $8.7mm.

In sum, Moody's is saying that thanks to the DoJ's filing, S&P's bondholders are "expected" to lose the present value of less than $10mm down the road. ("Less than" - because S&P was already on watch for downgrade prior to the Dept. of Justice's filing.)

We are the first to agree this analysis is imperfect, but it's worth discussion and we welcome refutations!  Tell us why we're wrong.

Tuesday, February 5, 2013

The S&P Lawsuit: Can It Fix the Rating System?

The government's lawsuit against S&P has triggered speculation about why DOJ singled out just one agency  and whether cases against the other two (Moody's and Fitch) will be forthcoming. One theory is that S&P was chosen because it downgraded US Treasury bonds in 2011. Two other options seem more likely: (1) the other two agencies may still be in settlement talks with DOJ, or (2) DOJ has a better case against S&P.

I was in Structured Finance at another rating firm in 2006 and 2007, and recall the headiness of the time. Revenues were exploding and half the money fell to the bottom line. Analysts were under pressure to keep up with the rapid flow of new securitization deals pouring in from Wall Street. Management had trouble hiring good people in the highly competitive environment. Meanwhile, everyone was aware that business could quickly be lost to competing rating agencies if investment banking clients were dissatisfied with the speed or nature of our conclusions.

In short, it was an environment that encouraged the cutting of corners - in terms of research quality, and, if the government allegations hold true, in terms of ethics - in fact, if the allegations are true, it seems S&P transcended the realm of ethical lapses and entered the land of outright fraud.

According to the complaint, S&P management instructed employees not to publish software and data updates that would have resulted in lower ratings. For example, pages 42-48 of the complaint detail how S&P management suppressed an update to the agency's LEVELS tool that relied on a much larger and more representative set of mortgages. (Recall the US Senate testimony of former S&P analyst Frank Raiter: “…S&P had developed better methods for determining default which did capture some of the variations among products that were to become evident at the advent of the crisis. It is my opinion that had these models been implemented we would have had an earlier warning about the performance of many of the new products that subsequently lead to such substantial losses. That, in turn, should have caused the loss estimates mentioned above to increase and could have thus caused some of these products to be withdrawn from the market as they would have been too expensive to put into bonds.”).

By cancelling a previously announced upgrade to LEVELS at the end of 2004, S&P was allegedly able to perpetuate the use of a flawed methodology which allowed investment banks to create deals with insufficient collateral subordinated to the senior AAA tranche. While cancelling this upgrade allowed S&P to remain competitive with Moody's and Fitch, it (allegedly) did a huge disservice to AAA investors such as the Western Federal Credit Union, on whose behalf the government filed its complaint.

Naturally, S&P denies this allegation and it remains to be seen whether the government can prove its case. While the gory details of who knew what will undoubtedly fascinate, I hope that the debate around this lawsuit has room for a discussion about how to solve the fundamental rating agency problem. Rather than merely consider who is to blame, we should focus on how to change the institutional structure of the industry to incent more positive behavior.

First, why should we even care about the rating agency business enough to bother reforming it? After all, as depicted by Michael Lewis in The Big Short and in other financial crisis chronicles, rating agency employees are just a bunch of bottom feeders wearing J.C. Penney suits and sucking up to the investment bankers who might one day hire them.

Whatever we think of rating agency employees (I, for one, never shopped at Penney's), the inescapable fact is that their output shapes much of our financial conversation. Discussion around the US budget deficit and the Eurozone sovereign debt crisis often focuses on how rating agencies will respond to political measures. S&P's upgrade of California - raising it above Illinois in state bond rating purgatory - was a major local news story last week. Enron filed for bankruptcy because it lost its investment grade rating. And, of course, toxic assets poisoned the financial system in the years leading up to 2007 because of the high ratings they received.

Ratings are essential to the financial system because they help direct the flow of capital. By bucketing debt instruments into different risk categories, rating agencies help determine their interest rates. This function - if executed well - optimizes the use of society's savings and thus contributes to economic growth.

Given the importance of ratings, we need alternatives to the way they are now produced, i.e. by for profit companies with known conflicts of interest using proprietary data and analytics together with closed door rating committee meetings.

A much better alternative would be a system based on open source rating software, with fully transparent inputs and outputs, and no rating committee discretion. This fully open, fully deterministic approach controls biases regardless of whether the analysis is funded by investors, issuers, foundations or governments. It also allows a distributed peer review process to occur over the internet. An excellent case for open source ratings appeared recently on Naked Capitalism. PF2 has advanced this idea by supporting my Public Sector Credit Framework - a simulation tool for rating government bonds.

The first question I get when I propose such an approach is how are you going to make money? I have thoughts about that, but let me respond here with another question:  why aren't more academics, pundits, politicians and regulators thinking of ways to make this operational model work?

Universities and foundations could fund rating transparency projects. The only such example right now is the National University of Singapore's Risk Management Institute. I have yet to find any foundation or academic willing to create such an institution in North America or Europe. 

Easy to blame a bunch of greedy people at rating agencies for the financial crisis. Much harder to put the proper incentives in place, to do the heavy intellectual lifting needed to really fix the rating system.